Wednesday, January 28, 2009

I kicked off the valuation class with a discourse (actually, more of a rant) about the bias in the valuation process and how it skews numbers. I firmly believe that bias is, by far, the biggest enemy of good valuations and that it is pervasive. By bias, I am referring not only to the preconceptions we bring into the valuation of a company but also to the payoff to doing the valuation. He who pays the prices sets the bias in motion, and the valuation reflects it. Thus, if I were an investment banker hired to value a target company in an acquisition, I am going to bias my value upwards, since I make money if the deal goes through but not if it does not. I am sure that Pfizer has an investment banking valuation of Wyeth, right now, that backs up their bid. In class today, I set up 12 different valuation scenarios and asked for guesses on the direction of the bias. Here is the link to the list:

So, what is the cure for bias? I am afraid that there isn't one. However, we can reduce bias by changing the process by which we pay for valuations.

1. No deal maker should ever be asked to analyze whether the deal makes sense. This is what we ask of investment bankers in acquisitions. The process will create bad valuations. I think that acquirers should pay a third party (one that makes money only for doing appraisals) for the valuation.

2. In legal processes, we should have less adversarial valuation, where the expert for one side comes in with a high number and the other side with the low number and the court splits the difference.

3. Trust, but verify. Even the biggest names in the business - Goldman, McKinsey - are susceptible to bias.

As someone who looks at other peoples' valuations all the time, what experience has taught me is that the most critical questions to ask in assessing a valuation are: Who paid the appraiser to do the valuation? What are the potential sources of bias? That tells me a great deal more than perusing the numbers.

Monday, January 26, 2009

As many of you know already, I view myself as a teacher first and everything else - academic, researcher, professor - second. There are many reasons why I love teaching but as I get ready for the first class of the Spring semester, here is one. I get to start with a completely fresh slate, with a new class and a new subject. Everything I have done before is irrelevant and any mistakes or accomplishments from the past are erased. That kind of new beginning is tough to find in any other profession. The closest you can get to it is when you get a new job at a company where you know no one.... But you cannot keep doing that every six months... as I get to...

My blogs over the next few months will reflect what I am talking about in my corporate finance and valuation classes. Obviously, I will not bore you with the details, but if you are so inclined, you should be able to peek in on the class, since the lectures are webcast. So, I am off to class! Even after 25 years of doing this, I am excited and I hope the excitement rubs off on those in the class.

Tuesday, January 20, 2009

As those of you who are on my mailing list (now about 15000 long) know, I just completed by annual update of data about a week ago. If you are unfamiliar with my data updates, you can get the data on my website:

I have been reporting industry averages for corporate finance and valuation variables (returns, betas, costs of capital multiples) for a while now: this is my 15th annual update for US companies, and my seventh for European, Japanese and Emerging Market companies. In most years, the changes over the previous year have been marginal, especially for developed market companies. But the 2009 update was very different. Here are some of the highlights:

1. Risk premiums: Both the equity risk premium and default spreads on debt jumped dramatically over the year. The equity risk premium started 2008 at 4,37% and ended the year at 6.43%, its highest value since 1978. The default spreads more than doubled, and in some cases tripled, over the year for every single ratings class; for instance, the spread on a Baa1 rated bond increased from 1.75% to 5.25%. This will have profound effects on valuation. The same company, with earnings, beta and rating unchanged, but with default spreads updated is worth about 40% less today (in intrinsic value terms) than it was a year ago. (One aside. The risk premiums for debt increased more than the risk premiums for equity, which has implications for the mix of financing used by firms).

2. Emerging Market risk: In a crisis, risky asset classes get hit the worst and the country risk premiums for emerging markets have increased for two reasons. One is that the base mature market premium is now higher. The second is that the premium you demand for an emerging market is now higher. For example, the equity risk premium for India has increased from 7% to 11%. The drop in the Sensex should be no surprise.

3. On a multiple basis, everything looks cheap: The sector averages for every multiple - revenue multiples, PE ratios and EV/EBITDA - seem to suggest that we are surrounded by bargains. Before you jump in, a note of caution. The prices are as of January 2009 but accounting numbers lag. The most recent fiscal year for most companies in January 2009 is the 2007 fiscal year. Even trailing 12-month data ends in September. We are scaling post-crisis prices to pre-crisis accounting numbers. Hence, the low multiples. I will do an update in May 2009 and those numbers should contain some of the crisis impact. I am afraid the mismatch will not disappear until the 2010 update.

One final note. I have been asked why I do these data updates and put them on my site. I would love to claim that I am the "Mother Theresa" of finance but I do it for purely selfish reasons. Curiosity drives me to look at the data, and since the tools to convert raw data to accessible data are easily accessible, I bear no cost in sharing what I find with the rest of the world. I hope you find the data useful.

Sunday, January 18, 2009

I just finished teaching my first corporate finance class in the post-crisis period (to an executive MBA class). Having taught this class for close to 25 years now, I was wondering how I would bring in the events of the last few months into the sessions and be able to draw out the implications for businesses. I must confess that it was a lot less trying than I thought it would be.

In broad terms, these are the corporate finance implications that I see for the near future and the long term:a. In investment analysis: I see a shift away from expected value and base case valuations that have dominated financial analysis for the last few decades to more probabilistic approaches. Since both the data and the tools (Crystal Ball, @Risk etc.) are accessible and available now to most of us, I think this shift is long overdue.

b. In risk and hurdle rates: For the near term, I see a move towards higher risk premiums for both equity and debt, reflecting recent history and changes in risk aversion. In the long term, I think that we have to become more dynamic in our assesments of risk parameters and premiums, since the assumption that these numbers don't change much has clearly been shaken. Put another way, we have to accept the fact that risk premiums can change quickly even in developed markets and even more so in emerging markets.

c. In capital strucure: If debt represents a trade off between tax benefits on one side and expected bankruptcy costs on the other, the last few months have clearly tilted the scales away from the use of debt. The probability of distress and the cost of distress have both increased, particularly so for large companies where the notion that capital markets would provide needed funds is no longer universally accepted. I expect to see debt ratios decrease as companies retool and a less cavalier use of short term financing to fund long term assets.

d. In dividend policy: In the short term, companies will value liquidity and cash balances will go up. In the long term, the events of the last few months will make companies even more wary about instituting and increasing dividends (because of the instability and unpredictability of earnings) and I would not be surprised to see even more of a shift towards flexible cash return policies (stock buybacks).

I feel more confortable now, going into the new semester. I don't have all of the answers but I feel that I have a framework for approaching the questions. The 450 students in my class will put me to the test and I am looking forward to it. You will have a ring side seat.

Wednesday, January 7, 2009

The news of the day is the resignation of the CEO of Satyam Computer, Ramalinga Raju, after admitting to fraud on a grand scale. Revenues and earnings were overstated massively over the last couple of years, and the company admitted that the cash that had been reported on the last balance sheet did not exist.

I would claim to be surprised and shocked by this news but I am not, becuase it is one in a long series of similar events - Enron, Parmalat, Worldcom etc. Rather than focus on Satyam and the sins of its managers, I would like to make some general points about accounting fraud and its consequences:

1. Self interest ultimately rules the day: The modern corporation is rife with conflicts of interests - between stockholders and bondholders, stockholders and managers, different classes of stockholders and different lenders. When decision makers are faced with a conflict of interest, self interest ultimately will win out. Note that Satyam's deception came to the surface when the company tried to buy stakes in two proprety companies owned by the Raju brothers.

2. Corporate governance matters: While we cannot do much about human beings acting in their self interest, we can put up roadblocks that prevent them from ripping off the rest of us. Having a board of directors tha asks tough questions and holds management accountable is critical to keeping managers/ founders in check. In this case, I have serious problems with the board of directors at Satyam and their oversight of the managers. I know at least 3 people on this board and believe that they are smart, honest people, but they were clearly led down the garden path. I have always had problems with the structuring of family companies in Asia, where families often control dozens of firms using a variety of devices including cross holdings and pyramid structures. When confronted, the families contend that they are "honorable and noble" and that they have the best interests of stockholders at heart. I don't think so!!!!

3. New Accounting and disclosure rules won't prevent fraud: The Indian government and accounting standards board will start writing new rules that they will claim will prevent this type of fraud. I seriously doubt it. Firms will always be one step ahead of the accounting rule makers when it comes to pulling off these heists.

What are the lessons for us as investors? When things look too good to be true, they are usually false. I am not familiar with Satyam's financials, but it may be worth looking at past statements to see if the clues were there that we chose to ignore. There is a strong need for forensic accounting... Just a warning! Fraud and malfeasance come to the surface when times are bad and I will expect to see a flood of Satyam-like cases all over India and China especially. Growth has masked the weaknesses of corporations in both countries and its absence will separate the wheat from the chaff.